“S.” sp. z o.o. had filed a requested a written interpretation (binding ruling) with the tax authorities. The company had asked the following question: when calculating the income ratio to which the tax rate referred to in Article 24d(1) of the A.P.C. may be applied, can the transfer pricing regulations be applied accordingly (mutatis mutandis) by applying the profit split method – residual analysis (the method listed in § 13(3)(2) of the Ordinance). The request was dismissed by the tax authorities, stating that it could not assess the position presented in the application, as this would go beyond the framework of the individual interpretation proceedings defined by the legislator. An appeal was filed by “S” sp. z o.o. with the regional court and the court ruled in favour of the company. An appeal was then filed by the tax authorities with the the Supreme Administrative Court. Judgement of the Supreme Administrative Court. The Court dismissed the appeal of the tax authorities and upheld the decision of the regional court. According to the Supreme Administrative Court, “S.” sp. z o.o. had a right to obtain reliable information as to how – in the actual state of affairs/future event pertaining to it – the tax authority interprets the tax regulations applicable to it, which may affect the correctness of its settlement, and in the case of determining the tax base. Excerpt “According to the Supreme Administrative Court, both the actual state of affairs/future event described by the applicant in its application and the question contained in the application were in fact a question about the validity of the subsumption of the actual state of affairs/future event presented in the application under the relevant provisions of tax law. Moreover, the applicant’s request did not concern the interpretation of provisions other than those of tax law. The court of first instance correctly assessed that the analysis of the application and the applicant’s position indicates that its primary objective is to obtain an answer to the question whether, in the factual state/future event presented in the application, the income ratio to which the tax rate referred to in Article 24d(1) of the Corporate Income Tax Act of 15 February 1992 (Journal of Laws of 2020, item 1406, as amended); hereinafter: the “p.d.o.p.” may be – when calculating the income ratio to which the tax rate referred to in Article 24d(1) of the Corporate Income Tax Act of 15 February 1992 (Journal of Laws of 2020, item 1406, as amended); hereinafter: the “p.d.o.p.” – applied accordingly (mutatis mutandis) the transfer pricing regulations by applying the profit split method – split analysis, according to the method listed in § 13(3)(2) of the Regulation of the Minister of Finance of 21 December 2018 on transfer pricing for corporate income tax (Journal of Laws of 2018, item 259 as amended); hereinafter: ‘the Regulation’. Since the company, in presenting its own legal assessment of the above-mentioned factual state/future event, stated that the provisions of Article 24d(3)-(8) of the u.p.d.o.p.. do not explicitly specify the method by which income from intellectual property referred to in Article 30ca para. 2(3) of the u.p.d.o.p.. (should be: Article 24d(2)(8) of the u.p.d.o.p.. – note of the court), according to it, the most appropriate method is the residual profit split method, in which the separation of income streams (from development and design activities) would take place in two stages appropriate for this method. However, this company’s own legal assessment of the presented facts/future event should have been subject to the assessment of the interpreting authority, since both the provisions of the p.d.o.p, as well as the aforementioned implementing regulation issued pursuant to Article 11j(1)(1)(2) of the u.p.d.o.p.. constitute provisions of tax law, within the meaning of Article 3(2) of the A.p.l. This provision stipulates that whenever provisions of the tax law are referred to in the Act – it is understood as the provisions of tax acts, provisions of agreements on avoidance of double taxation ratified by the Republic of Poland and other international agreements on tax issues ratified by the Republic of Poland, as well as provisions of executive acts issued on the basis of tax acts. Undoubtedly, therefore, the company requested an individual interpretation of the provisions of tax law, i.e. the provision of Article 24d(2)(8) of the VAT Act and the provisions of the implementing act to the VAT Act, i.e. the aforementioned regulation. Moreover, what is important in the case, the applicant, when describing the facts/future event, directly classified its activity as research and development activity, and its aim was to confirm whether it is possible to adopt, mutatis mutandis, for the calculation of the income ratio to which the tax rate referred to in Article 24d(1) of the A.P.C. may be applied. – transfer pricing regulations by applying the profit split method – split analysis, according to the method listed in § 13(3)(2) of the aforementioned regulation.” Click here for English translation Click here for other translation ...

H-Customs GmbH – the applicant and appellant – is a subsidiary of H, Japan. In the period at issue, from 17 October 2009 to 30 September 2010, H-Customs GmbH imported more than 1,000 consignments of various goods from H, which it had cleared for free circulation under customs and tax law at the defendant HZA (Hauptzollamt – German Customs Authorities). H-Customs GmbH declared the prices invoiced to it by H Japan as the customs value. Some of the imported articles were duty-free; for the articles that were not duty-free, the HZA imposed customs duties of between 1.4 % and 6.7 % by means of import duty notices. In 2012, H-Customs GmbH applied to the HZA for a refund of customs duties for the goods imported during the period at issue in the total amount of… €. It referred to an Advance Pricing Agreement (APA) concluded between it and H for transactions in the tax field and stated that the adjustments to the transfer prices carried out on the basis of the APA had not been taken into account when declaring the goods for customs clearance and that it was now doing so. The APA had already been concluded in 2009 as part of a mutual agreement procedure under the agreement between the Federal Republic of Germany and Japan for the avoidance of double taxation with regard to taxes on income and certain other taxes. The Federal Central Tax Office and the local Tax Office had approved the APA. The customs authorities had not been involved. The APA covered the sale of end products and components from H Japan to H-Customs GmbH as well as other business transactions related to the trade in goods. On the basis of the APA, transfer prices were determined for certain business transactions. In the process, H initially invoiced H-Customs GmbH a certain amount for each of the goods it supplied. The sum of these amounts was reviewed after the end of the business year and, if necessary, corrected in favour of or to the detriment of H-Customs GmbH. In this way it was to be ensured that the transfer prices stood up to an arm’s length comparison. For this purpose, the German and Japanese authorities involved chose the so-called residual profit split method at the request of H-Customs GmbH and with reference to point 3.19 of the transfer pricing principles of the Organisation for Economic Cooperation and Development. According to this method, the combined profit of H-Customs GmbH and H Japan from the audited intra-group transactions was split in two stages. In a first stage, each party was first allocated a sufficient profit to achieve a minimum return. As a starting point, the returns on sales routinely achieved by comparable companies with similar operating profiles were used. In order to calculate the routine profit to be allocated, the full cost mark-up was used as profit indicators for H and the return on sales for the applicant. After apportioning the routine profit, in a second step the remaining residual profit was apportioned proportionally according to the profit apportionment factors. After determining the routine profit and the residual profit, the target range of the applicant’s return on sales (operating margin) was set. If the applicant’s actual profit was outside the target range, the profit was adjusted to the upper or lower limit of the target range and credits or debits were made to the applicant. H-Customs GmbH’s return on sales was below the target range set out in the APA. For this reason, H-Customs GmbH and H Japan adjusted the transfer prices after the end of the accounting period for 2009/2010 by way of a credit note in the amount of … €. The report of the Main Customs Office Cologne, Federal Customs Valuation Office, to which the Fiscal Court (Finanzgericht, FG) refers in the contested judgment, states that the amount had been allocated to various product groups on the basis of an allocation key; there had been no explanation of the individual product groups. The apportionment formula applied had been specified by H; the applicant was not aware of the basis on which H had determined this apportionment formula. H-Customs GmbH had calculated the duty to be refunded in its view by reducing the sum of all original customs values by the amount of the adjustment from the APA and then applying an average duty rate of 1.02% rounded up to the original or the adjusted customs value. The refund amount sought by the applicant resulted from the difference between the two values determined in this way. H-Customs GmbH did not allocate the adjustment amount to the individual imported goods. In its decision of 4 June 2014, the German Customs Authorities rejected the refund application on the grounds that the method chosen by the applicant in the form of a global correction of the total price was not compatible with Article 29(1) of the Customs Code in conjunction with Article 144 of the Implementing Regulation. Article 144 of the Customs Code Implementing Regulation (CCIP). Due to the fact that the amount of the adjustment was not broken down by product, it was ultimately not possible to clarify and prove to which specific import goods the adjustment exactly related and in what amount it was to be made for them. By decision of 2 July 2015, the German Customs Authorities rejected H-Customs GmbH’s objection as unfounded. An appeal was then filed by H-Customs GmbH with the Tax Court. In a judgement issued in 2019 the appeal was dismissed and the assessment of the German Customs Authorities upheld. An appeal was then filed with the Bundesfinanzhof Judgement of the Bundesfinanzhof The Court dismissed the appeal as unfounded and upheld the decision of the Tax Court. Excerpts “The contested decision by which the HZA refused to refund the import duties sought by the plaintiff is lawful (§ 101 sentence 1 FGO). The applicant is not entitled to a refund of part of the duty it paid under the first ...

Residual profit split preferred to other methods. (i) USP is a manufacturer of athletic apparel sold under the AA trademark, to which FP owns the worldwide rights. USP sells AA trademark apparel in countries throughout the world, but prior to year 1, USP did not sell its merchandise in Country X. In year 1, USP acquires an uncontrolled Country X company which becomes its wholly-owned subsidiary, XSub. USP enters into an exclusive distribution arrangement with XSub in Country X. Before being acquired by USP in year 1, XSub distributed athletic apparel purchased from uncontrolled suppliers and resold that merchandise to retailers. After being acquired by USP in year 1, XSub continues to distribute merchandise from uncontrolled suppliers and also begins to distribute AA trademark apparel. Under a separate agreement with USP, XSub uses its best efforts to promote the AA trademark in Country X, with the goal of maximizing sales volume and revenues from AA merchandise. (ii) Prior to year 1, USP executed long-term endorsement contracts with several prominent professional athletes. These contracts give USP the right to use the names and likenesses of the athletes in any country in which AA merchandise is sold during the term of the contract. These contracts remain in effect for five years, starting in year 1. Before being acquired by USP, XSub renewed a long-term agreement with SportMart, an uncontrolled company that owns a nationwide chain of sporting goods retailers in Country X. XSub has been SportMart’s primary supplier from the time that SportMart began operations. Under the agreement, SportMart will provide AA merchandise preferred shelf-space and will feature AA merchandise at no charge in its print ads and seasonal promotions. In consideration for these commitments, USP and XSub grant SportMart advance access to new products and the right to use the professional athletes under contract with USP in SportMart advertisements featuring AA merchandise (subject to approval of content by USP). (iii) Assume that it is possible to segregate all transactions by XSub that involve distribution of merchandise acquired from uncontrolled distributors (non-controlled transactions). In addition, assume that, apart from the activities undertaken by USP and XSub to promote AA apparel in Country X, the arm’s length compensation for other functions performed by USP and XSub in the Country X market in years 1 and following can be reliably determined. At issue in this Example 12 is the application of the residual profit split analysis to determine the appropriate division between USP and XSub of the balance of the operating profits from the Country X market, that is the portion attributable to nonroutine contributions to the marketing and promotional activities. (iv) A functional analysis of the marketing and promotional activities conducted in the Country X market, as described in this example, indicates that both USP and XSub made nonroutine contributions to the business activity. USP contributed the long-term endorsement contracts with professional athletes. XSub contributed its long-term contractual rights with SportMart, which were made more valuable by its successful, long-term relationship with SportMart. (v) Based on the facts and circumstances, including the fact that both USP and XSub made valuable nonroutine contributions to the marketing and promotional activities and an analysis of the availability (or lack thereof) of comparable and reliable market benchmarks, the Commissioner determines that the most reliable measure of an arm’s length result is the residual profit split method in § 1.482-9(g). The residual profit split analysis would take into account both routine and nonroutine contributions by USP and XSub, in order to determine an appropriate allocation of the combined operating profits in the Country X market from the sale of AA merchandise and from related promotional and marketing activities ...

Residual profit split method preferred to other methods. (i) USC is a U.S. company that develops, manufactures and sells communications equipment. EC is the European subsidiary of USC. EC is an established company that carries out extensive research and development activities and develops, manufactures and sells communications equipment in Europe. There are extensive transactions between USC and EC. USC licenses valuable technology it has developed to EC for use in the European market but EC also licenses valuable technology it has developed to USC. Each company uses components manufactured by the other in some of its products and purchases products from the other for resale in its own market. (ii) Detailed accounting information is available for both USC and EC and adjustments can be made to achieve a high degree of consistency in accounting practices between them. Relatively reliable allocations of costs, income and assets can be made between the business activities that are related to the controlled transactions and those that are not. Relevant marketing and research and development expenditures can be identified and reasonable estimates of the useful life of the related intangibles are available so that the capitalized value of the intangible development expenses of USC and EC can be calculated. In this case there is no reason to believe that the relative value of these capitalized expenses is substantially different from the relative value of the intangible property of USC and EC. Furthermore, comparables are identified that could be used to estimate a market return for the routine contributions of USC and EC. Based on these facts, the residual profit split could provide a reliable measure of an arm’s length result. (iii) There are no uncontrolled transactions involving property that is sufficiently comparable to much of the tangible and intangible property transferred between USC and EC to permit use of the comparable uncontrolled price method or the comparable uncontrolled transaction method. Uncontrolled companies are identified in Europe and the United States that perform somewhat similar activities to USC and EC; however, the activities of none of these companies are as complex as those of USC and EC and they do not use similar levels of highly valuable intangible property that they have developed themselves. Under these circumstances, the uncontrolled companies may be useful in determining a market return for the routine contributions of USC and EC, but that return would not reflect the value of the intangible property employed by USC and EC. Thus, none of the uncontrolled companies is sufficiently similar so that reliable results would be obtained using the resale price, cost plus, or comparable profits methods. Moreover, no uncontrolled companies can be identified that engaged in sufficiently similar activities and transactions with each other to employ the comparable profit split method. (iv) Given the difficulties in applying the other methods, the reliability of the internal data on USC and EC, and the fact that acceptable comparables are available for deriving a market return for the routine contributions of USC and EC, the residual profit split method is likely to provide the most reliable measure of an arm’s length result in this case ...

(i) For simplicity of calculation in this Example 2, all financial flows are assumed to occur at the beginning of each period. USP is a U.S. automobile manufacturing company that has completed significant research on the development of diesel-electric hybrid engines that, if they could be successfully manufactured, would result in providing a significant increased fuel economy for a wide variety of motor vehicles. Successful commercialization of the diesel-electric hybrid engine will require the development of a new class of advanced battery that will be light, relatively cheap to manufacture and yet capable of holding a substantial electric charge. FS, a foreign subsidiary of USP, has completed significant research on developing lithium-ion batteries that appear likely to have the requisite characteristics. At the beginning of Year 1, USP enters into a CSA with FS to further develop diesel-electric hybrid engines and lithium-ion battery technologies for eventual commercial exploitation. Under the CSA, USP will have the right to exploit the diesel-electric hybrid engine and lithium-ion battery technologies in the United States, while FS will have the right to exploit such technologies in the rest of the world. The partially developed diesel-electric hybrid engine and lithium-ion battery technologies owned by USP and FS, respectively, are reasonably anticipated to contribute to the development of commercially exploitable automobile engines and therefore the rights in both these technologies constitute platform contributions of USP and of FS for which compensation is due under PCTs. At the time of inception of the CSA, USP owns operating intangibles in the form of self-developed marketing intangibles which have significant value in the United States, but not in the rest of the world, and that are relevant to exploiting the cost shared intangibles. Similarly, FS owns self-developed marketing intangibles which have significant value in the rest of the world, but not in the United States, and that are relevant to exploiting the cost shared intangibles. Although the new class of diesel-electric hybrid engine using lithium-ion batteries is not yet ready for commercial exploitation, components based on this technology are beginning to be incorporated in current-generation gasoline-electric hybrid engines and the rights to make and sell such products are transferred from USP to FS and vice-versa in conjunction with the inception of the CSA, following the same territorial division as in the CSA. (ii) USP’s estimated RAB share is 66.7%. During Year 1, it is anticipated that sales in USP’s territory will be $1000X in Year 1. Sales in FS’s territory are anticipated to be $500X. Thereafter, as revenue from the use of components in gasoline-electric hybrids is supplemented by revenues from the production of complete diesel-electric hybrid engines using lithium-ion battery technology, anticipated sales in both territories will increase rapidly at a rate of 50% per annum through Year 4. Anticipated sales are then anticipated to increase at a rate of 40% per annum for another 4 years. Sales are then anticipated to increase at a rate of 30% per annum through Year 10. Thereafter, sales are anticipated to decrease at a rate of 5% per annum for the foreseeable future as new automotive drivetrain technologies displace diesel-electric hybrid engines and lithium-ion batteries. Total operating expenses attributable to product exploitation (including operating cost contributions) equal 40% of sales per year for both USP and FS. USP and FS estimate that the total market return on these routine contributions to the CSA will amount to 6% of these operating expenses. USP is expected to bear 2⁄3 of the total cost contributions for the foreseeable future. Cost contributions are expected to total $375X in Year 1 (of which $250X are borne by USP) and increase at a rate of 25% per annum through Year 6. In Years 7 through 10, cost contributions are expected to increase 10% a year. Thereafter, cost contributions are expected to decrease by 5% a year for the foreseeable future. (iii) USP and FS determine the present value of the stream of FS’s reasonably anticipated residual divisional profit, which is the stream of FS’s reasonably anticipated divisional profit or loss, minus the market returns for routine contributions, minus operating cost contributions, minus cost contributions. USP and FS determine, based on the considerations discussed in paragraph (g)(2)(v) of this section, that the appropriate discount rate is 12% per year. Therefore, the present value of the nonroutine residual divisional profit in USP’s territory is $41,727X and in CFC’s territory is $20,864X. (iv) After analysis, USP and FS determine that, in the United States the relative value of the technologies contributed by USP and FS to the CSA and of the operating intangibles used by USP in the exploitation of the cost shared intangibles (reported as equaling 100 in total), equals: USP’s platform contribution (59.5); FS’s platform contribution (25.5); and USP’s operating intangibles (15). Consequently, the present value of the arm’s length amount of the PCT Payments that USP should pay to FS for FS’s platform contribution is $10,640X (.255 × $41,727X). Similarly, USP and FS determine that, in the rest of the world, the relative value of the technologies contributed by USP and FS to the CSA and of the operating intangibles used by FS in the exploitation of the cost shared intangibles can be divided as follows: USP’s platform contribution (63); FS’s platform contribution (27); and FS’s operating intangibles (10). Consequently, the present value of the arm’s length amount of the PCT Payments that FS should pay to USP for USP’s platform contribution is $13,144X (.63 × $20,864X). Therefore, FS is required to make a net payment to USP with a present value of $2,504X ($13,144X − 10,640X). (v) The calculations for this Example 2 are displayed in the following tables: Calculation of USP’s PCT Payment to FS Time Period (Y = Year) (TV = Terminal Value) Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 TV Discount Period 0 1 2 3 4 5 6 7 8 9 9 [1] Sales 1000 1500 2250 3375 4725 6615 9261 12965 16855 21912 [2] Growth Rate 50% 50% 50% 40% 40% 40% 40% 30% 30% [3] Exploitation ...

(i) For simplicity of calculation in this Example 1, all financial flows are assumed to occur at the beginning of each period. USP, a U.S. electronic data storage company, has partially developed technology for a type of extremely small compact storage devices (nanodisks) which are expected to provide a significant increase in data storage capacity in various types of portable devices such as cell phones, MP3 players, laptop computers and digital cameras. At the same time, USP’s wholly-owned subsidiary, FS, has developed significant marketing intangibles outside the United States in the form of customer lists, ongoing relations with various OEMs, and trademarks that are well recognized by consumers due to a long history of marketing successful data storage devices and other hardware used in various types of consumer electronics. At the beginning of Year 1, USP enters into a CSA with FS to develop nanodisk technologies for eventual commercial exploitation. Under the CSA, USP will have the right to exploit nanodisks in the United States, while FS will have the right to exploit nanodisks in the rest of the world. The partially developed nanodisk technologies owned by USP are reasonably anticipated to contribute to the development of commercially exploitable nanodisks and therefore the rights in the nanodisk technologies constitute platform contributions of USP for which compensation is due under PCTs. FS does not have any platform contributions for the CSA. Due to the fact that nanodisk technologies have yet to be incorporated into any commercially available product, neither USP nor FS transfers rights to make or sell current products in conjunction with the CSA. (ii) Because only in FS’s territory do both controlled participants make significant nonroutine contributions, USP and FS determine that they need to determine the relative value of their respective contributions to residual divisional profit or loss attributable to the CSA Activity only in FS’s territory. FS anticipates making no nanodisk sales during the first year of the CSA in its territory with revenues in Year 2 reaching $200 million. Revenues through Year 5 are reasonably anticipated to increase by 50% per year. The annual growth rate for revenues is then expected to decline to 30% per annum in Years 6 and 7, 20% per annum in Years 8 and 9 and 10% per annum in Year 10. Revenues are then expected to decline 10% in Year 11 and 5% per annum, thereafter. The routine costs (defined here as costs other than cost contributions, routine platform and operating contributions, and nonroutine contributions) that are allocable to this revenue in calculating FS’s divisional profit or loss, are anticipated to equal $40 million for the first year of the CSA and $130 for the second year and $200 and $250 million in Years 3 and 4. Total operating expenses attributable to product exploitation (including operating cost contributions) equal 52% of sales per year. FS undertakes routine distribution activities in its markets that constitute routine contributions to the relevant business activity of exploiting nanodisk technologies. USP and FS estimate that the total market return on these routine contributions will amount to 6% of the routine costs. FS expects its cost contributions to be $60 million in Year 1, rise to $100 million in Years 2 and 3, and then decline again to $60 million in Year 4. Thereafter, FS’s cost contributions are expected to equal 10% of revenues. (iii) USP and FS determine the present value of the stream of the reasonably anticipated residuals in FS’s territory over the duration of the CSA Activity of the divisional profit or loss (revenues minus routine costs), minus the market returns for routine contributions, the operating cost contributions, and the cost contributions. USP and FS determine, based on the considerations discussed in paragraph (g)(2)(v) of this section, that the appropriate discount rate is 17.5% per annum. Therefore, the present value of the nonroutine residual divisional profit is $1,395 million. (iv) After analysis, USP and FS determine that the relative value of the nanodisk technologies contributed by USP to CSA (giving effect only to its value in FS’s territory) is roughly 150% of the value of FS’s marketing intangibles (which only have value in FS’s territory). Consequently, 60% of the nonroutine residual divisional profit is attributable to USP’s platform contribution. Therefore, FS’s PCT Payments should have an expected present value equal to $837 million (.6 × $1,395 million). (v) The calculations for this Example 1 are displayed in the following table: Time Period (Y = Year) (TV = Terminal Value) Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10 Y11 TV Discount Period 0 1 2 3 4 5 6 7 8 9 10 10 [1] Sales 0 200 300 450 675 878 1141 1369 1643 1807 1626 [2] Growth Rate 50% 50% 50% 30% 30% 20% 20% 10% −10% [3] Exploitation Costs and Operating Cost Contributions (52% of Sales [1]) 40 130 200 250 351 456 593 712 854 940 846 [4] Return on [3] (6% of [3]) 2.4 8 12 15 21 27 36 43 51 56 51 [5] Cost Contributions (10% of Sales [1] after Year 5) 60 100 100 60 68 88 114 137 164 181 163 [6] Residual Profit = [1] minus {[3] + [4] + [5]} −102 −38 −12 125 235 306 398 477 573 630 567 2395 [7] Residual Profit [6] Discounted at 17.5% discount rate −102 −32 −9 77 124 137 151 154 158 148 113 477 [8] Sum of all amounts in [7] for all time periods = $1,395 million [9] Relative value in FS’s division of USP’s nanotechnology to FS’s marketing intangibles = 150% [10] Profit Split (USP) 60% = 1.5 × [11] [11] Profit Split (FS) 40% [12] FS’s PCT Payments [8] × [10] = $1,395 million × 60% = $837 million ...

The following examples illustrate the principles of this paragraph (g)(7): ...

Like the methods described in §§ 1.482-3 through 1.482-5 and § 1.482-9(c), the carveout on account of market returns for routine contributions relies exclusively on external market benchmarks. As indicated in § 1.482-1(c)(2)(i), as the degree of comparability between the controlled participants and uncontrolled transactions increases, the relative weight accorded the analysis under this method will increase. In addition, to the extent the allocation of nonroutine residual divisional profit or loss is not based on external market benchmarks, the reliability of the analysis will be decreased in relation to an analysis under a method that relies on market benchmarks. Finally, the reliability of the analysis under this method may be enhanced by the fact that all the controlled participants are evaluated under the residual profit split. However, the reliability of the results of an analysis based on information from all the controlled participants is affected by the reliability of the data and the assumptions pertaining to each controlled participant. Thus, if the data and assumptions are significantly more reliable with respect to one of the controlled participants than with respect to the others, a different method, focusing solely on the results of that party, may yield more reliable results ...

The reliability of the results derived from the residual profit split is affected by the quality of the data and assumptions used to apply this method. In particular, the following factors must be considered: (1) The reliability of the allocation of costs, income, and assets between the relevant business activity and the controlled participants’ other activities that will affect the reliability of the determination of the divisional profit or loss and its allocation among the controlled participants. See § 1.482-6(c)(2)(ii)(C)(1). (2) The degree of consistency between the controlled participants and uncontrolled taxpayers in accounting practices that materially affect the items that determine the amount and allocation of operating profit or loss affects the reliability of the result. See § 1.482-6(c)(2)(ii)(C)(2). (3) The reliability of the data used and the assumptions made in estimating the relative value of the nonroutine contributions by the controlled participants. In particular, if capitalized costs of development are used to estimate the relative value of nonroutine contributions, the reliability of the results is reduced relative to the reliability of other methods that do not require such an estimate. This is because, in any given case, the costs of developing a nonroutine contribution may not be related to its market value and because the calculation of the capitalized costs of development may require the allocation of indirect costs between the relevant business activity and the controlled participant’s other activities, which may affect the reliability of the analysis ...

The derivation of the present value of nonroutine residual divisional profit or loss includes a carveout on account of market returns for routine contributions. Thus, the comparability considerations that are relevant for that purpose include those that are relevant for the methods that are used to determine market returns for the routine contributions ...

Whether results derived from this method are the most reliable measure of the arm’s length result is determined using the factors described under the best method rule in § 1.482-1(c). Thus, comparability and quality of data, reliability of assumptions, and sensitivity of results to possible deficiencies in the data and assumptions, must be considered in determining whether this method provides the most reliable measure of an arm’s length result. The application of these factors to the residual profit split in the context of the relevant business activity of developing and exploiting cost shared intangibles is discussed in paragraphs (g)(7)(iv)(B) through (D) of this section ...

...

For purposes of this paragraph (g)(7), any routine platform or operating contributions, the valuation and PCT Payments for which are determined and made independently of the residual profit split method, are treated similarly to cost contributions and operating cost contributions, respectively. Accordingly, wherever used in this paragraph (g)(7), the term “routine contributions” shall not include routine platform or operating contributions, and wherever the terms “cost contributions” and “operating cost contributions” appear in this paragraph (g)(7), they shall include net routine platform contributions and net routine operating contributions, respectively, as defined in paragraph (g)(4)(vii) of this section. However, treatment of net operating contributions as operating cost contributions shall be coordinated with the treatment of other routine contributions pursuant to paragraphs (g)(4)(iii)(B) and (7)(iii)(B) of this section so as to avoid duplicative market returns to such contributions ...

Any amount of the present value of a controlled participant’s nonroutine residual divisional profit or loss that is allocated to another controlled participant represents the present value of the PCT Payments due to that other controlled participant for its platform contributions to the relevant business activity in the relevant division. For purposes of paragraph (j)(3)(ii) of this section, the present value of a PCT Payor’s PCT Payments under this paragraph shall be deemed reduced to the extent of the present value of any PCT Payments owed to it from other controlled participants under this paragraph (g)(7). The resulting remainder may be converted to a fixed or contingent form of payment in accordance with paragraph (h) (Form of payment rules) of this section ...

The relative values of the controlled participants’ nonroutine contributions must be determined so as to reflect the most reliable measure of an arm’s length result. Relative values may be measured by external market benchmarks that reflect the fair market value of such nonroutine contributions. Alternatively, the relative value of nonroutine contributions may be estimated by the capitalized cost of developing the nonroutine contributions and updates, as appropriately grown or discounted so that all contributions may be valued on a comparable dollar basis as of the same date. If the nonroutine contributions by a controlled participant are also used in other business activities (such as the exploitation of make-or-sell rights described in paragraph (c)(4) of this section), an allocation of the value of the nonroutine contributions must be made on a reasonable basis among all the business activities in which they are used in proportion to the relative economic value that the relevant business activity and such other business activities are anticipated to derive over time as the result of such nonroutine contributions ...

The present value of nonroutine residual divisional profit or loss in each controlled participant’s division must be allocated among all of the controlled participants based upon the relative values, determined as of the date of the PCTs, of the PCT Payor’s as compared to the PCT Payee’s nonroutine contributions to the PCT Payor’s division. For this purpose, the PCT Payor’s nonroutine contribution consists of the sum of the PCT Payor’s nonroutine operating contributions and the PCT Payor’s RAB share of the PCT Payor’s nonroutine platform contributions. For this purpose, the PCT Payee’s nonroutine contribution consists of the PCT Payor’s RAB share of the PCT Payee’s nonroutine platform contributions ...

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The present value of each controlled participant’s nonroutine residual divisional profit or loss must be determined to reflect the most reliable measure of an arm’s length result. The present value of nonroutine residual divisional profit or loss equals the present value of the stream of the reasonably anticipated residuals over the duration of the CSA Activity of divisional profit or loss, minus market returns for routine contributions, minus operating cost contributions, minus cost contributions, using a discount rate appropriate to such residuals in accordance with paragraph (g)(2)(v) of this section. As used in this paragraph (g)(7), the phrase “market returns for routine contributions” includes market returns for operating cost contributions and excludes market returns for cost contributions ...

Under the residual profit split method, the present value of each controlled participant’s residual divisional profit or loss attributable to nonroutine contributions (nonroutine residual divisional profit or loss) is allocated between the controlled participants that each furnish significant nonroutine contributions (including platform or operating contributions) to the relevant business activity in that division ...

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The relative value of each controlled participant’s contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity, consistent with the best method analysis described in § 1.482-1(c) and (d). Such an allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers, each performing functions similar to those of the various controlled participants engaged in the relevant business activity. The profit allocated to any particular controlled participant is not necessarily limited to the total operating profit of the group from the relevant business activity. For example, in a given year, one controlled participant may earn a profit while another controlled participant incurs a loss. In addition, it may not be assumed that the combined operating profit or loss from the relevant business activity should be shared equally, or in any other arbitrary proportion ...

The residual profit split method evaluates whether the allocation of combined operating profit or loss attributable to one or more platform contributions subject to a PCT is arm’s length by reference to the relative value of each controlled participant’s contribution to that combined operating profit or loss. The combined operating profit or loss must be derived from the most narrowly identifiable business activity (relevant business activity) of the controlled participants for which data are available that include the CSA Activity. The residual profit split method may not be used where only one controlled participant makes significant nonroutine contributions (including platform or operating contributions) to the CSA Activity. The provisions of § 1.482-6 shall apply to CSAs only to the extent provided and as modified in this paragraph (g)(7). Any other application to a CSA of a residual profit method not described in paragraphs (g)(7)(ii) and (iii) of this section will constitute an unspecified method for purposes of sections 482 and 6662(e) and the regulations under those sections ...

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Application of Residual Profit Split. (i) XYZ is a U.S. corporation that develops, manufactures and markets a line of products for police use in the United States. XYZ’s research unit developed a bulletproof material for use in protective clothing and headgear (Nulon). XYZ obtains patent protection for the chemical formula for Nulon. Since its introduction in the U.S., Nulon has captured a substantial share of the U.S. market for bulletproof material. (ii) XYZ licensed its European subsidiary, XYZ-Europe, to manufacture and market Nulon in Europe. XYZ-Europe is a well- established company that manufactures and markets XYZ products in Europe. XYZ-Europe has a research unit that adapts XYZ products for the defense market, as well as a well-developed marketing network that employs brand names that it developed. (iii) XYZ-Europe’s research unit alters Nulon to adapt it to military specifications and develops a high-intensity marketing campaign directed at the defense industry in several European countries. Beginning with the 1995 taxable year, XYZ-Europe manufactures and sells Nulon in Europe through its marketing network under one of its brand names. (iv) For the 1995 taxable year, XYZ has no direct expenses associated with the license of Nulon to XYZ-Europe and incurs no expenses related to the marketing of Nulon in Europe. For the 1995 taxable year, XYZ-Europe’s Nulon sales and pre-royalty expenses are $500 million and $300 million, respectively, resulting in net pre-royalty profit of $200 million related to the Nulon business. The operating assets employed in XYZ-Europe’s Nulon business are $200 million. Given the facts and circumstances, the district director determines under the best method rule that a residual profit split will provide the most reliable measure of an arm’s length result. Based on an examination of a sample of European companies performing functions similar to those of XYZ-Europe, the district director determines that an average market return on XYZ-Europe’s operating assets in the Nulon business is 10 percent, resulting in a market return of $20 million (10% × $200 million) for XYZ- Europe’s Nulon business, and a residual profit of $180 million. (v) Since the first stage of the residual profit split allocated profits to XYZ-Europe’s contributions other than those attributable to highly valuable intangible property, it is assumed that the residual profit of $180 million is attributable to the valuable intangibles related to Nulon, i.e., the European brand name for Nulon and the Nulon formula (including XYZ-Europe’s modifications). To estimate the relative values of these intangibles, the district director compares the ratios of the capitalized value of expenditures as of 1995 on Nulon-related research and development and marketing over the 1995 sales related to such expenditures. (vi) Because XYZ’s protective product research and development expenses support the worldwide protective product sales of the XYZ group, it is necessary to allocate such expenses among the worldwide business activities to which they relate. The district director determines that it is reasonable to allocate the value of these expenses based on worldwide protective product sales. Using information on the average useful life of its investments in protective product research and development, the district director capitalizes and amortizes XYZ’s protective product research and development expenses. This analysis indicates that the capitalized research and development expenditures have a value of $0.20 per dollar of global protective product sales in 1995. (vii) XYZ-Europe’s expenditures on Nulon research and development and marketing support only its sales in Europe. Using information on the average useful life of XYZ-Europe’s investments in marketing and research and development, the district director capitalizes and amortizes XYZ-Europe’s expenditures and determines that they have a value in 1995 of $0.40 per dollar of XYZ-Europe’s Nulon sales. (viii) Thus, XYZ and XYZ-Europe together contributed $0.60 in capitalized intangible development expenses for each dollar of XYZ-Europe’s protective product sales for 1995, of which XYZ contributed one-third (or $0.20 per dollar of sales). Accordingly, the district director determines that an arm’s length royalty for the Nulon license for the 1995 taxable year is $60 million, i.e., one-third of XYZ-Europe’s $180 million in residual Nulon profit ...

The provisions of this paragraph (c)(3) are illustrated by the following example ...

Like the methods described in §§ 1.482-3, 1.482-4, 1.482-5, and 1.482-9, the first step of the residual profit split relies exclusively on external market benchmarks. As indicated in § 1.482-1(c)(2)(i), as the degree of comparability between the controlled and uncontrolled transactions increases, the relative weight accorded the analysis under this method will increase. In addition, to the extent the allocation of profits in the second step is not based on external market benchmarks, the reliability of the analysis will be decreased in relation to an analysis under a method that relies on market benchmarks. Finally, the reliability of the analysis under this method may be enhanced by the fact that all parties to the controlled transaction are evaluated under the residual profit split. However, the reliability of the results of an analysis based on information from all parties to a transaction is affected by the reliability of the data and the assumptions pertaining to each party to the controlled transaction. Thus, if the data and assumptions are significantly more reliable with respect to one of the parties than with respect to the others, a different method, focusing solely on the results of that party, may yield more reliable results ...

The reliability of the results derived from the residual profit split is affected by the quality of the data and assumptions used to apply this method. In particular, the following factors must be considered – (1) The reliability of the allocation of costs, income, and assets as described in paragraph (c)(2)(ii)(C)(1) of this section; (2) Accounting consistency as described in paragraph (c)(2)(ii)(C)(2) of this section; (3) The reliability of the data used and the assumptions made in valuing the intangible property contributed by the participants. In particular, if capitalized costs of development are used to estimate the value of intangible property, the reliability of the results is reduced relative to the reliability of other methods that do not require such an estimate, for the following reasons. First, in any given case, the costs of developing the intangible may not be related to its market value. Second, the calculation of the capitalized costs of development may require the allocation of indirect costs between the relevant business activity and the controlled taxpayer’s other activities, which may affect the reliability of the analysis. Finally, the calculation of costs may require assumptions regarding the useful life of the intangible property ...

The first step of the residual profit split relies on market benchmarks of profitability. Thus, the comparability considerations that are relevant for the first step of the residual profit split are those that are relevant for the methods that are used to determine market returns for the routine contributions. The second step of the residual profit split, however, may not rely so directly on market benchmarks. Thus, the reliability of the results under this method is reduced to the extent that the allocation of profits in the second step does not rely on market benchmarks ...

Whether results derived from this method are the most reliable measure of the arm’s length result is determined using the factors described under the best method rule in § 1.482-1(c). Thus, comparability and the quality of data and assumptions must be considered in determining whether this method provides the most reliable measure of an arm’s length result. The application of these factors to the residual profit split is discussed in paragraph (c)(3)(ii)(B), (C), and (D) of this section ...

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In many cases, nonroutine contributions of a taxpayer to the relevant business activity may be contributions of intangible property. For purposes of paragraph (c)(3)(i)(B)(1) of this section, the relative value of nonroutine intangible property contributed by taxpayers may be measured by external market benchmarks that reflect the fair market value of such intangible property. Alternatively, the relative value of nonroutine intangible property contributions may be estimated by the capitalized cost of developing the intangible property and all related improvements and updates, less an appropriate amount of amortization based on the useful life of each intangible property. Finally, if the intangible property development expenditures of the parties are relatively constant over time and the useful life of the intangible property contributed by all parties is approximately the same, the amount of actual expenditures in recent years may be used to estimate the relative value of nonroutine intangible property contributions ...

The allocation of income to the controlled taxpayer’s routine contributions will not reflect profits attributable to each controlled taxpayer’s contributions to the relevant business activity that are not routine (nonroutine contributions). A nonroutine contribution is a contribution that is not accounted for as a routine contribution. Thus, in cases where such nonroutine contributions are present, there normally will be an unallocated residual profit after the allocation of income described in paragraph (c)(3)(i)(A) of this section. Under this second step, the residual profit generally should be divided among the controlled taxpayers based upon the relative value of their nonroutine contributions to the relevant business activity. The relative value of the nonroutine contributions of each taxpayer should be measured in a manner that most reliably reflects each nonroutine contribution made to the controlled transaction and each controlled taxpayer’s role in the nonroutine contributions. If the nonroutine contribution by one of the controlled taxpayers is also used in other business activities (such as transactions with other controlled taxpayers), an appropriate allocation of the value of the nonroutine contribution must be made among all the business activities in which it is used ...

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The first step allocates operating income to each party to the controlled transactions to provide a market return for its routine contributions to the relevant business activity. Routine contributions are contributions of the same or a similar kind to those made by uncontrolled taxpayers involved in similar business activities for which it is possible to identify market returns. Routine contributions ordinarily include contributions of tangible property, services and intangible property that are generally owned by uncontrolled taxpayers engaged in similar activities. A functional analysis is required to identify these contributions according to the functions performed, risks assumed, and resources employed by each of the controlled taxpayers. Market returns for the routine contributions should be determined by reference to the returns achieved by uncontrolled taxpayers engaged in similar activities, consistent with the methods described in §§ 1.482-3, 1.482-4, 1.482-5 and 1.482-9 ...

Under this method, the combined operating profit or loss from the relevant business activity is allocated between the controlled taxpayers following the two-step process set forth in paragraphs (c)(3)(i)(A) and (B) of this section ...

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The allocation of profit or loss under the profit split method must be made in accordance with one of the following allocation methods – (i) The comparable profit split, described in paragraph (c)(2) of this section; or (ii) The residual profit split, described in paragraph (c)(3) of this section ...

Example to Illustrate the Application of the Residual Profit Split Method 1. The success of an electronics product is linked to the innovative technological design both of its electronic processes and of its major component. That component is designed and manufactured by associated company A, is transferred to associated company B which designs and manufactures the rest of the product, and is distributed by associated company C. Information exists to verify by means of a resale price method that the distribution functions and risks of Company C are being appropriately rewarded by the transfer price of the finished product from B to C. 2. The most appropriate method to price the component transferred from A to B may be a CUP, if a sufficiently similar comparable could be found. See paragraph 2.14 of the Guidelines. However, since the component transferred from A to B reflects the innovative technological advance enjoyed by company A in this market, in this example it proves impossible (after the appropriate functional and comparability analyses have been carried out) to find a reliable CUP to estimate the correct price that A could command at arm’s length for its product. Calculating a return on A’s manufacturing costs could however provide an estimate of the profit element which would reward A’s manufacturing functions, ignoring the profit element attributable to the intangible used therein. A similar calculation could be performed on company B’s manufacturing costs, to give an estimate of B’s profit derived from its manufacturing functions, ignoring the profit element attributable to its intangible. Since B’s selling price to C is known and is accepted as an arm’s length price, the amount of the residual profit accrued by A and B together from the exploitation of their respective intangible property can be determined. See paragraphs 2.108 and 2.121 of the Guidelines. At this stage the proportion of this residual profit properly attributable to each enterprise remains undetermined. 3. The residual profit may be split based on an analysis of the facts and circumstances that might indicate how the additional reward would have been allocated at arm’s length. Paragraph 2.121 of the Guidelines. The R&D activity of each company is directed towards technological design relating to the same class of item, and it is established for the purposes of this example that the relative amounts of R&D expenditure reliably measure the relative value of the companies’ contributions. See paragraph 2.120 of the Guidelines. This means that each company’s contribution to the product’s technological innovation may reliably be measured by their relative expenditure on research and development, so that, if A’s R&D expenditure is 15 and B’s 10, the residual could be split 3/5 for A and 2/5 for B. 4. Some figures may assist in following the example: a) Profit & Loss of A and B A                     B Sales                                     50                    100 Less: Purchases                             (10)                  (50) Manufacturing costs               (15)                  (20) Gross profits                          25                      30 Less: R&D                             15                    10 Operating expenses       10     (25)         10      (20) Net profit                                 0                     10 b) Determine routine profit on manufacturing by A and B, and calculate total residual profit 5. It is established, for both jurisdictions, that third-party comparable manufacturers without innovative intangible property earn a return on manufacturing costs (excluding purchases) of 10% (ratio of net profit to the direct and indirect costs of manufacturing).1 See paragraph 2.121 of the Guidelines. A’s manufacturing costs are 15, and so the return on costs would attribute to A a manufacturing profit of 1.5. B’s equivalent costs are 20, and so the return on costs would attribute to B a manufacturing profit of 2.0. The residual profit is therefore 6.5, arrived at by deducting from the combined net profit of 10 the combined manufacturing profit of 3.5. c) Allocate residual profit 6. The initial allocation of profit (1.5 to A and 2.0 to B) rewards the manufacturing functions of A and B, but does not recognise the value of their respective R&D that has resulted in a technologically advanced product. That residual can, therefore, be split between A and B based on their share of total R&D costs, since, for the purposes of this example2, it can reliably be assumed that the companies’ relative expenditure on R&D accurately reflects their relative contributions to the value of the product’s technological innovation. A’s R&D expenditure is 15 and B’s 10, giving combined R&D expenditure of 25. The residual is 6.5 which may be allocated 15/25 to A and 10/25 to B, resulting in a share of 3.9 and 2.6 respectively, as below: A’s share 6.5 x 15/25= 3.9 B’s share 6.5 x 10/25= 2.6. 1  This 10% return does not technically correspond to a cost plus mark-up in its strictest sense because it yields net profit rather than gross profit. But neither does the 10% return correspond to a TNMM margin in its strictest sense, since the cost base does not include operating expenses. The net return on manufacturing costs is being used as a convenient and practical first stage of the profit split method, because it simplifies the determination of the amount of residual net profit attributable to intangible property. 2 But see paragraph 6.27 of the Guidelines. d) Recalculate Profits 7. A’s net profits would thus become 1.5 + 3.9 = 5.4. B’s net profits would thus become 2.0 + 2.6 = 4.6. The revised P ...

Promgas s.p.a. is 50% owned by the Italian company Eni s.p.a. and 50% owned by the Russian company Gazprom Export. It deals with the purchase and sale of natural gas of Russian origin destined for the Italian market. It sells the gas to a single Italian entity not belonging to the group, Edison spa, on the basis of a contract signed on 24 January 2000. In essence, Promgas s.p.a. performes intermediary function between the Russian company, Gazprom Export (exporter of the gas), and the Italian company, Edison s.p.a. (final purchaser of the gas). Following an audit for FY 2005/06, the tax authorities – based on the Transaction Net Margin Method – held that the operating margin obtained by Promgas s.p.a. (0.23% in 2025 and 0.06% in 2006) were not in line with the results that the company could have achieved at arm’s length. Applying an operating margin of l.39% resulted in a arm’s length profit of €4,227,438.07, for the year 2005, which was €3,426.803.00 higher than the profit declared by the company. Promgas s.p.a. appealed against the notice of assessment, which was upheld by the Provincial Tax Commission of Milan, with sentence no. 356/44/11, notified on 23/12/2011. The tax authorities then filed an appeal with the Regional Tax Commission of Lombardy which upheld the the tax authorities main appeal and rejected the company’s cross appeal. Promgas s.p.a. then filed an appeal with the Supreme Court Judgement of the Supreme Court The Supreme Court remanded the cast to the Regional Tax Commission of Lombardy Excerpts “…. 8.1. The failure to examine the facts put forward by the taxpayer company to oppose the set of comparables identified by the Revenue Agency resulted in a defect in the overall reasoning of the contested judgment, as denounced by the appellant company in its fifth and sixth grounds of complaint. 8.2. As is clear from the criteria indicated in the OECD Guidelines referred to above, in order for the application of the TNMM to be reliable, it is necessary to conduct an analysis of comparability that passes through the two moments of the choice of the tested party and the identification of the comparable companies, an identification that, under free market conditions (arm’s length principle), presupposes a “comparison” (internal or external) between the tested party and comparable companies that satisfies the five factors of comparability indicated by the OECD criteria (characteristics of goods and services functional analysis; contractual terms underlying the intra-group transaction; business strategies; economic conditions). It is through such a comparison that the factors that may significantly influence the net profit indicators (see paragraph 7.9 below) are identified on the basis of the facts and circumstances of the case. 8.3. Indeed, the reliability of such a method, according to the prevailing practice and interpretation, must pass through the following steps – selection of the tested party for the analysis; – determination of the financial results relating to the controlled transactions – selection of the investigation period; – identification of comparable companies; – accounting adjustments to the financial statements of the tested party and differences in accounting practices, provided that such adjustments are appropriate and possible; – assessment of whether adjustments are appropriate or necessary to take account of differences between the tested party and the identified comparable companies in terms of risks assumed or functions performed; – selection of a reliable profitability profit level indicator (so-called Profit Leverage/ Indicator, or PLI). 8.4. The CTR’s failure to verify the circumstances alleged by the taxpayer, resulted, in essence, in the pretermission of the comparability analysis for the selection of the TNMM applied to the case, and thus, of the procedure for the identification of comparable transactions and the use of relevant information to ensure the reliability of the analysis and the compliance of the PLI, or PLI, with the principle of free competition, or rather, the reliability of the selected TNMM. 9. The seventh ground of appeal – alleging breach of Article 6(1) of Legislative Decree 18/12/1997, no. The seventh ground of appeal – which alleges infringement of Article 6(1) of Legislative Decree No 472 of 18 December 1997, on the ground that the Regional Tax Commission held that the financial penalties applied by the Tax Office were lawful, erroneously excluding the existence of a ground of non-punishability, without specifically verifying the percentage of discrepancy between the amount declared by the company (0.23%) and the amount assessed by the Administration (1.39%) – is considered to be absorbed by the acceptance of the fifth and sixth grounds of appeal. 10. In conclusion, the appeal must be upheld limited to the fifth and sixth grounds of appeal, with absorption of the seventh and dismissal of the remainder. The judgement must be set aside in relation to the upheld grounds, with a reference back to the CTR, in a different composition, for a new examination of the merits of the dispute from the point of view of the standards of comparability relating to the method chosen and the penalty profile also in the light of the more favourable ius superveniens.” Click here for English translation Click here for other translation ...

Olympus Medical Systems India is a subsidiary of Olympus Corp and engaged in the import, sale and maintenance of medical equipment in India. For FY 2012 and 2013 the company reported losses. An transfer pricing audit was initiated by the tax authorities and later an assessment was issued. Since Olympus India had failed to provide audited financials of its associated enterprises to determine the overall profits of the group, it adopted the Resale Price Method using the Bright Line Test approach. An appeal was then filed by Olympus with the Tax Appellate Tribunal. Olympus India argued that the tax authorities was erroneous in adopting the Residual Profit Split Method in determining the arm’s length price of the AMP expenses and furthermore that the tax authorities could not make an adjustment without having information on the total profits of the group. Judgement of the Tax Appellate Tribunal The tribunal held that Olympus India should not benefit for non-cooperation in providing audited financials of associated enterprises. Olympus was obligated to submit the audited financials of the associated enterprises. Failure to do so could justify an assessment by applying the Residual Profit Split Method in the determination of the arm’s length price of the AMP expenses. Excerpts “The TPO has benchmarked using the Residual Profit Split Method. For applying the Residual Profits Split Method, it is incumbent upon the TPO first to combine profit from the international transaction of incurring AMP expenses and then split the combined profit in proportion to the relative contribution made by both the entities. In order to work out the combined profit in the transaction the financials/profitability of the AE’s is very much essential. In the instant case, the Assessee has refused to submit the profitability of the AE’s, therefore the TPO has adopted the RPSM.” “In our opinion, the Assessee who is entering into the International transaction is duty bound to maintain and produce the same before the Department when it is asked to produce as per Section 92D of Income Tax Act R/w. Rule 10D and 92D of Income Tax Rules, 1962. If the assessee doesn’t provide the financials of its AE’s, the TPO/AO/DRP can very well invoke the provisions of Income tax Provisions of Income-Tax Act and the Rules framed there under to call for such records not only from the country of residence but also from any other country in cases of AE’s and decide the issue.” “In our opinion the TPO/Assessing Officer cannot apply wrong method in the absence of material ie: audited financials of AE. On the other hand, TPO/AO cannot even give the benefit as well to the Assessee for non cooperation for providing the audited financials of AE.” “By following the above said binding decision in Assessee’s own case and also for the reasons mentioned above, we hold that the international transaction of AMP functions exists in the case of the Assessee and restore the issue to the TPO for following the direction of the Hon’ble Delhi High Court in the case of Sony Ericsson (supra) for benchmarking under TNMM in aggregated manner along with the purchase of goods from the AE’s or in the segregated manner, after taking into account appropriate comparables or applying of Resale price method or Cost Plus Method or Profit Split Method keeping in view the findings of the Hon’ble Delhi High Court. Needles to say that, the Assessee shall be given opportunity of being heard. Further Assessee is directed to provide all the relevant documents including the financials of its AE’s if required, failing to which the Authorities can act in accordance with law by invoking the relevant provisions.” ...

Adidas India Marketing Pvt. Ltd. is engaged in distribution and marketing of a range of Adidas and tailor made branded athletic and lifestyle products. Following an audit for FY 2016-2017, an assessment had been issued by the tax authorities where adjustments had been made to (1) advertising, promotion and marketing activities in Adidas India which was considered to have benefitted related parties in the Adidas group, (2) royalty/license payments to the group which was considered excessive and (3) fees paid by Adidas India to related parties which was considered “fees for technical services” (FTS) subjekt to Indian withholding tax. Following an unfavorable decision on the first complaint, an appeal was filed by Adidas with the Income Tax Appellate Tribunal. Judgement of the ITAT The Tribunal decided predominantly in favor of Adidas. Issues 1 and 2 was restored back to the tax authorities for a new decision in accordance with the directions given by the Tribunal, and issue 3 was set aside ...

Where the contributions of the parties are such that some can be reliably valued by reference to a one-sided method and benchmarked using comparables, while others cannot, the application of a residual analysis may be appropriate. A residual analysis divides the relevant profits from the controlled transactions under examination into two categories. In the first category are profits attributable to contributions which can be reliably benchmarked: typically less complex contributions for which reliable comparables can be found. Ordinarily this initial remuneration would be determined by applying one of the traditional transaction methods or a transactional net margin method to identify the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by a second category of contributions which may be unique and valuable, and/or are attributable to a high level of integration or the shared assumption of economically significant risks. Typically, the allocation of the residual profit among the parties will be based on the relative value of the second category of contributions of the parties in the same way as in the application of the contribution analysis outlined above and in accordance with the guidance as described in Section C.5 ...

A Oy, the parent company of group A, had not charged a royalty (the so-called concept fee) to all local companies in the group. The tax authorities had determined the level of the local companies’ arm’s length results and thus the amounts of royalties not collected from them on the basis of the results of nine comparable companies. The comparable companies’ performance levels were -0,24 %, 0,60 %, 1,07 %, 2,90 %, 3,70 %, 5,30 %, 8,40 %, 12,30 % and 13,50 %. The interquartile range of the results had been 1.1-8.4% and the median 3.7%. The tax inspectors had set the routine rate of return for all local companies at 4,5 %, which was also used by A Ltd as the basis for the concept fee. A’s taxes had been adjusted accordingly to the detriment of the company. Before the Supreme Administrative Court, A Oy claimed that the adjustment point for taxable income should be the upper limit of the full range of 13,5 % in the first instance and the upper limit of the quartile range of 8,4 % in the second instance. The Supreme Administrative Court, taking into account the number of comparable companies, the dispersion of their results and the width of the overall range, as well as the fact that the results of five comparable companies had been below the 4.5% used in the A Ltd Concept Fee scheme, held that, in determining the level of the arm’s length results of the group’s local companies, the range could have been narrowed to the interquartile range of the results of the comparable companies within the meaning of paragraph 3.57 of the OECD Transfer Pricing Guidelines. The royalties charged to the local companies would have been at market rates if A Oy had charged the local companies a concept fee or other royalty so that the local companies’ results would have been within the interquartile range. In such a case, A Oy’s trading income would not have been lower than it would otherwise have been, within the meaning of Article 31(1) of the Tax Procedure Act, as a result of the non-arm’s length pricing. To the extent that the level of the results of the local companies had exceeded the quartile range, the amounts of the additions to the company’s taxable income should have been calculated by adjusting the results of the local companies to the arm’s length level, i.e. to the upper limit of the quartile range of 8,4 %. The Supreme Administrative Court therefore annulled the tax adjustments made to the detriment of the company and cancelled the increases in the company’s taxable income in so far as they were based on the local companies’ profit margins between 4,5 % and 8,4 % for the tax years 2010 to 2012. Click here for English translation Click here for other translation ...

Where the contributions of the parties are such that some can be reliably valued by reference to a one-sided method and benchmarked using comparables, while others cannot, the application of a residual analysis may be appropriate. A residual analysis divides the relevant profits from the controlled transactions under examination into two categories. In the first category are profits attributable to contributions which can be reliably benchmarked: typically less complex contributions for which reliable comparables can be found. Ordinarily this initial remuneration would be determined by applying one of the traditional transaction methods or a transactional net margin method to identify the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by a second category of contributions which may be unique and valuable, and/or are attributable to a high level of integration or the shared assumption of economically significant risks. Typically, the allocation of the residual profit among the parties will be based on the relative value of the second category of contributions of the parties in the same way as in the application of the contribution analysis outlined above and in accordance with the guidance as described in section C.5 ...

C Uyemura & Co, Ltd. is engaged in the business of manufacturing and selling plating chemicals and had entered into a series of controlled transactions with foreign group companies granting licenses to use intangibles (know-how related to technology and sales) – and provided technical support services by sending over technical experts. The company had used a CUP method to price these transactions based on “internal comparables”. The tax authorities found that the amount of the consideration paid to C Uyemura & Co, Ltd for the licenses and services had not been at arm’s length and issued an assessment where the residual profit split method was applied to determine the taxable profit for the fiscal years 2000 – 2004. C Uyemura & Co, Ltd disapproved of the assessment. The company held that it was inappropriate to use a residual profit split method and that there were errors in the calculations performed by the tax authorities. Judgement of the Court The Court dismissed the appeal of C Uyemura & Co, Ltd. and affirmed the assessment made by the Japanese tax authority. On company’s use of the CUP method the Court concluded that there were significant differences between the controlled transactions and the selected “comparable” transactions in terms of licences, services and circumstances in which the transactions were took place. Therefore the CUP method was not the best method to price the controlled transactions. The Court recognised that C Uyemura & Co, Ltd had intangible assets created by its research and development activities. The Court also recognised that the Taiwanese, Malaysian and Singaporean subsidiaries had created intangible assets by penetrating regional markets and cultivating and maintaining customer relationships. The Court found the transactions should be aggregated and that the price should be determined for the full packaged deal – not separately for each transaction. Click here for English translation ...

[See Chapter II, Part III, Section C of these Guidelines for general guidance on the application of the transactional profit split method. The assumptions about arm’s length arrangements in the following examples are intended for illustrative purposes only and should not be taken as prescribing adjustments and arm’s length arrangements in actual cases of particular industries. While they seek to demonstrate the principles of the sections of the Guidelines to which they refer, those principles must be applied in each case according to the specific facts and circumstances of that case. Furthermore, the comments below relate to the application of a transactional profit split method in the situations where, given the facts and circumstances of the case and in particular the comparability (including functional) analysis of the transaction and the review of the information available on uncontrolled comparables, such a method is found to be the most appropriate method to be used.] Below are some illustrations of the effect of choosing a measure of profits to determine the combined profits to be split when applying a transactional profit split method. 2. Assume A and B are two associated enterprises situated in two different tax jurisdictions. Both manufacture the same widgets and incur expenditure that results in the creation of an intangible asset which they can mutually use. For the purpose of this example, it is assumed that the nature of this particular asset is such that the value of the asset contribution attributable to each of A and B in the year in question is proportional to A and B’s relative expenditure on the asset in that (It should be noted that this assumption will not always be true in practice. This is because there may be cases where the relative values of asset contributions attributable to each party would be based on accumulated expenditure from the prior, as well as current years.) Assume A and B exclusively sell products to third parties. Assume that it is determined that the most appropriate method to be used is a residual profit split method, that the manufacturing activities of A and B are simple, non-unique transactions that should be allocated an initial return of 10% of the Cost of Goods Sold and that the residual profit should be split in proportion to A’s and B’s intangible asset expenditure. The following figures are for illustration only: A B Combined A + B Sales 100 300 400 Cost Of Goods Sold 60 170 230 Gross Profit 40 130 170 Overhead expenses 3 6 9 Other operating expenses 2 4 6 Intangible asset expenditure 30 40 70 Operating Profit 5 80 85 Step one: determining the initial return for the non-unique manufacturing transactions (Cost of Goods Sold + 10% in this example) A 60 + (60 * 10 %) = 66 ➔ Initial return for the manufacturing transactions of A =  6 B 170 + (170 * 10 %) = 187 ➔ Initial return for the manufacturing transactions of B =     17 Total profit allocated through initial returns (6+17) =       23 Step two: determining the residual profit to be split a) In case it is determined as the operating profit:  Combined Operating Profit 85 Profit already allocated (initial returns for manufacturing transactions) 23 Residual profit to be split in proportion to A’s and B’s intangible asset expenditure 62   Residual profit allocated to A: 62 * 30/70 26.57 Residual profit allocated to B: 62 * 40/70 35.43 Total profits allocated to A: 6 (initial return) + 26.57 (residual) 32.57 Total profits allocated to B: 17 (initial return) + 35.43 (residual) 52.43 Total 85 b) In case it is determined as the operating profit before overhead expenses (assuming it is determined that the overhead expenses of A and B do not relate to the transaction examined and should be excluded from the determination of the combined profits to be split):   A B Combined A + B Sales 100 300 400 Cost Of Goods Sold 60 170 230 Gross Profit 40 130 170 Other operating expenses 2 4 6 Intangible asset expenditure 30 40 70 Operating Profit before overhead expenses 8 86 94 Overhead expenses 3 6 9 Operating Profit 5 80 85   Combined Operating Profit before overhead expenses 94 Profit already allocated (initial returns for manufacturing transactions) 23 Residual profit before overhead expenses to be split in proportion to A’s and B’s intangible asset expenditure 71   Residual profit allocated to A: 71 * 30/70 30.43 Residual profit allocated to B: 71 * 40/70 40.57 Total profits allocated to A: 6 (initial return) + 30.43 (residual) – 3 (overhead expenses) 33.43 Total profits allocated to B: 17 (initial return) + 40.57 (residual) – 6 (overhead expenses) 51.57 Total 85 5. s shown in the above example, excluding some specific items from the determination of the combined profits to be split implies that each party remains responsible for its own expenses in relation to it. As a consequence, the decision whether or not to exclude some specific items must be consistent with the comparability (including functional) analysis of the transaction. 6. As another example, in some cases it may be appropriate to back out a category of expenses to the extent that the allocation key used in the residual profit split analysis relies on those For example, in cases where relative expenditure contributing to the development of an intangible asset is determined to be the most appropriate profit split factor, residual profits can be based on operating profits before that expenditure. After determining the split of residual profits, each associated enterprise then subtracts its own expenditure. This can be illustrated as follows. Assume the facts are the same as in the example at paragraph 2 above and assume the overhead expenses are not excluded from the determination of the residual profit to be split. Step one: determining the basic return for the manufacturing activities (Cost of Goods Sold + 10% in this example) Same as at paragraph 3. Step two: determining the residual profit to ...

[See Chapter II, Part III, Section C of these Guidelines for general guidance on the application of the profit split method. The adjustments and assumptions about arm’s length arrangements in the examples that follow are intended for illustrative purposes only and should not be taken as prescribing adjustments and arm’s length arrangements in actual cases or particular industries. While they seek to demonstrate the principles of the Sections of the Guidelines to which they refer, those principles must be applied in each case according to the specific facts and circumstances of that case.] 1. The success of an electronics product is linked to the innovative technological design both of its electronic processes and of its major component. That component is designed and manufactured by associated company A, is transferred to associated company B which designs and manufactures the rest of the product, and is distributed by associated company C. Information exists to verify by means of a resale price method that the distribution functions and risks of Company C are being appropriately rewarded by the transfer price of the finished product from B to C. 2. The most appropriate method to price the component transferred from A to B may be a CUP, if a sufficiently similar comparable could be found. See paragraph 2.15 of the Guidelines. However, since the component transferred from A to B reflects the innovative technological advance enjoyed by company A in this market, in this example it proves impossible (after the appropriate functional and comparability analyses have been carried out) to find a reliable CUP to estimate the correct price that A could command at arm’s length for its product. Calculating a return on A’s manufacturing costs could however provide an estimate of the profit element which would reward A’s manufacturing functions, ignoring the profit element attributable to the intangible used therein. A similar calculation could be performed on company B’s manufacturing costs, to give an estimate of B’s profit derived from its manufacturing functions, ignoring the profit element attributable to its intangible. Since B’s selling price to C is known and is accepted as an arm’s length price, the amount of the residual profit accrued by A and B together from the exploitation of their respective intangible property can be determined. See paragraphs 2.114 and 2.127 of the Guidelines. At this stage the proportion of this residual profit properly attributable to each enterprise remains undetermined. 3. The residual profit may be split based on an analysis of the facts and circumstances that might indicate how the additional reward would have been allocated at arm’s length. Paragraph 2.127 of the The R&D activity of each company is directed towards technological design relating to the same class of item, and it is established for the purposes of this example that the relative amounts of R&D expenditure reliably measure the relative value of the companies’ contributions. See paragraph 2.126 of the Guidelines. This means that each company’s contribution to the product’s technological innovation may reliably be measured by their relative expenditure on research and development, so that, if A’s R&D expenditure is 15 and B’s 10, the residual could be split 3/5 for A and 2/5 for B. 4. Some figures may assist in following the example: a) Profit & Loss of A and B   A B Sales 50 100 Less: Purchases (10) (50) Manufacturing costs (15) (20) Gross profits 25 30 Less: R&D 15 10 Operating expenses 10 (25) 10 (20) Net profit 0 10 b) Determine routine profit on manufacturing by A and B, and calculate total residual profit 5. It is established, for both jurisdictions, that third-party comparable manufacturers without innovative intangible property earn a return on manufacturing costs (excluding purchases) of 10% (ratio of net profit to the direct and indirect costs of manufacturing).1 See paragraph 2.127 of the A’s manufacturing costs are 15, and so the return on costs would attribute to A a manufacturing profit of 1.5. B’s equivalent costs are 20, and so the return on costs would attribute to B a manufacturing profit of 2.0. The residual profit is therefore 6.5, arrived at by deducting from the combined net profit of 10 the combined manufacturing profit of 3.5. c)  Allocate residual profit 6. The initial allocation of profit (1.5 to A and 2.0 to B) rewards the manufacturing functions of A and B, but does not recognise the value of their respective R&D that has resulted in a technologically advanced product. That residual can, therefore, be split between A and B based on their share of total R&D costs, since, for the purposes of this example2, it can reliably be assumed that the companies’ relative expenditure on R&D accurately reflects their relative contributions to the value of the product’s technological innovation. A’s R&D expenditure is 15 and B’s 10, giving combined R&D expenditure of 25. The residual is 6.5 which may be allocated 15/25 to A and 10/25 to B, resulting in a share of 3.9 and 2.6 respectively, as below: A’s share 6.5 x 15/25= 3.9 B’s share 6.5 x 10/25= 2.6. d)  Recalculate Profits 7. A’s net profits would thus become 5 + 3.9 = 5.4. B’s net profits would thus become 2.0 + 2.6 = 4.6. The revised P & L for tax purposes would appear as: A B Sales 55.4 100 Less: Purchases (10) (55.4) Manufacturing costs (15) (20) Gross profit 30.4 24.6 Less: R& D 15 10 Operating expenses 10 (25) 10 (20) Net profit 5.4 4.6 Note 8. The example is intended to exemplify in a simple manner the mechanisms of a residual profit split and should not be interpreted as providing general guidance as to how the arm’s length principle should apply in identifying arm’s length comparables and determining an appropriate split. It is important that the principles that it seeks to illustrate are applied in each case taking into account the specific facts and circumstances of the case. In particular, it should be noted that the allocation of the residual split ...

In some cases an analysis could be performed, perhaps as part of a residual profit split or as a method of splitting profits in its own right, by taking into account the discounted cash flow to the parties to the controlled transactions over the anticipated life of the business. One of the situations in which this may be an effective method could be where a start-up is involved, cash flow projections were carried out as part of assessing the viability of the project, and capital investment and sales could be estimated with a reasonable degree of certainty. However, the reliability of such an approach will depend on the use of an appropriate discount rate, which should be based on market benchmarks. In this regard, it should be noted that industry- wide risk premiums used to calculate the discount do not distinguish between particular companies let alone segments of businesses, and estimates of the relative timing of receipts can be problematic. Such an approach, therefore, would require considerable caution and should be supplemented where possible by information derived from other methods ...

An alternative approach to how to apply a residual analysis could seek to replicate the outcome of bargaining between independent enterprises in the free market. In this context, in the first stage, the initial remuneration provided to each participant would correspond to the lowest price an independent seller reasonably would accept in the circumstances and the highest price that the buyer would be reasonably willing to pay. Any discrepancy between these two figures could result in the residual profit over which independent enterprises would bargain. In the second stage, the residual analysis therefore could divide this pool of profit based on an analysis of any factors relevant to the associated enterprises that would indicate how independent enterprises might have split the difference between the seller’s minimum price and the buyer’s maximum price ...

A residual analysis divides the combined profits from the controlled transactions under examination in two stages. In the first stage, each participant is allocated an arm’s length remuneration for its non-unique contributions in relation to the controlled transactions in which it is engaged. Ordinarily this initial remuneration would be determined by applying one of the traditional transaction methods or a transactional net margin method, by reference to the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by any unique and valuable contribution by the participants. In the second stage, any residual profit (or loss) remaining after the first stage division would be allocated among the parties based on an analysis of the facts and circumstances, following the guidance as described at paragraphs 2.138-2.151 for splitting the combined profits. 3An example illustrating the application of the residual profit split is found in Annex II to Chapter II ...

In the Tokyo High Court judgment, dated 13 May 2015, Honda Motor Company Limited, a major Japanese automobile manufacturer, obtained a cancellation of a tax assessment of ¥25.4 billion. The court held that the tax authorities had erred in the selection of companies comparable to the tested party (Honda’s foreign subsidiary in Brazil). The tested party was doing business in the Free Economic Zone of Manaus in Brazil – whereas the selected comparables was located outside the zone. The existence of Manaus Tax benefit was considered a market condition affecting the degree of profitability. Hence profits of the Honda subsidiary in Manaus could not be determined based on similar independent Brazilian companies outside the zone and therefore not comparable. Click here for English Translation ...

Annex II to Chapter II Example to Illustrate the Application of the Residual Profit Split Method 1. The success of an electronics product is linked to the innovative technological design both of its electronic processes and of its major component. That component is designed and manufactured by associated company A, is transferred to associated company B which designs and manufactures the rest of the product, and is distributed by associated company C. Information exists to verify by means of a resale price method that the distribution functions and risks of Company C are being appropriately rewarded by the transfer price of the finished product from B to C. 2. The most appropriate method to price the component transferred from A to B may be a CUP, if a sufficiently similar comparable could be found. See paragraph 2.14 of the Guidelines. However, since the component transferred from A to B reflects the innovative technological advance enjoyed by company A in this market, in this example it proves impossible (after the appropriate functional and comparability analyses have been carried out) to find a reliable CUP to estimate the correct price that A could command at arm’s length for its product. Calculating a return on A’s manufacturing costs could however provide an estimate of the profit element which would reward A’s manufacturing functions, ignoring the profit element attributable to the intangible used therein. A similar calculation could be performed on company B’s manufacturing costs, to give an estimate of B’s profit derived from its manufacturing functions, ignoring the profit element attributable to its intangible. Since B’s selling price to C is known and is accepted as an arm’s length price, the amount of the residual profit accrued by A and B together from the exploitation of their respective intangible property can be determined. See paragraphs 2.108 and 2.121 of the Guidelines. At this stage the proportion of this residual profit properly attributable to each enterprise remains undetermined. 3. The residual profit may be split based on an analysis of the facts and circumstances that might indicate how the additional reward would have been allocated at arm’s length. Paragraph 2.121 of the Guidelines. The R&D activity of each company is directed towards technological design relating to the same class of item, and it is established for the purposes of this example that the relative amounts of R&D expenditure reliably measure the relative value of the companies’ contributions. See paragraph 2.120 of the Guidelines. This means that each company’s contribution to the product’s technological innovation may reliably be measured by their relative expenditure on research and development, so that, if A’s R&D expenditure is 15 and B’s 10, the residual could be split 3/5 for A and 2/5 for B. 4. Some figures may assist in following the example: a) Profit & Loss of A and B A                     B Sales                                     50                    100 Less: Purchases                             (10)                  (50) Manufacturing costs               (15)                  (20) Gross profits                          25                      30 Less: R&D                             15                    10 Operating expenses       10     (25)         10      (20) Net profit                                 0                     10 b) Determine routine profit on manufacturing by A and B, and calculate total residual profit 5. It is established, for both jurisdictions, that third-party comparable manufacturers without innovative intangible property earn a return on manufacturing costs (excluding purchases) of 10% (ratio of net profit to the direct and indirect costs of manufacturing).1 See paragraph 2.121 of the Guidelines. A’s manufacturing costs are 15, and so the return on costs would attribute to A a manufacturing profit of 1.5. B’s equivalent costs are 20, and so the return on costs would attribute to B a manufacturing profit of 2.0. The residual profit is therefore 6.5, arrived at by deducting from the combined net profit of 10 the combined manufacturing profit of 3.5. c) Allocate residual profit 6. The initial allocation of profit (1.5 to A and 2.0 to B) rewards the manufacturing functions of A and B, but does not recognise the value of their respective R&D that has resulted in a technologically advanced product. That residual can, therefore, be split between A and B based on their share of total R&D costs, since, for the purposes of this example2, it can reliably be assumed that the companies’ relative expenditure on R&D accurately reflects their relative contributions to the value of the product’s technological innovation. A’s R&D expenditure is 15 and B’s 10, giving combined R&D expenditure of 25. The residual is 6.5 which may be allocated 15/25 to A and 10/25 to B, resulting in a share of 3.9 and 2.6 respectively, as below: A’s share 6.5 x 15/25= 3.9 B’s share 6.5 x 10/25= 2.6. 1  This 10% return does not technically correspond to a cost plus mark-up in its strictest sense because it yields net profit rather than gross profit. But neither does the 10% return correspond to a TNMM margin in its strictest sense, since the cost base does not include operating expenses. The net return on manufacturing costs is being used as a convenient and practical first stage of the profit split method, because it simplifies the determination of the amount of residual net profit attributable to intangible property. 2 But see paragraph 6.27 of the Guidelines. d) Recalculate Profits 7. A’s net profits would thus become 1.5 + 3.9 = 5.4. B’s net profits would thus become 2.0 + 2.6 ...